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November 13, 2012

Should Advisors Have to Disclose All Pressures to Maximize Revenues?

Ron Rhoades was kind enough to post a thoughtful comment to my Oct. 31 blog, “The Bonus Debate,” about whether brokers should be forced to disclose their recruiting bonuses to clients. As usual, his position is well-reasoned and knowledgeable, but what isn’t so usual is that I find myself on the other side of this particular issue. But before we get to that, let me first say that I have the greatest respect for Ron as one of the foremost thought leaders in the financial planning community, and that his untimely resignation as chairman of the NAPFA Board was both a loss to NAPFA and the profession. With that said, I have to admit that his thinking about broker bonuses leaves me a bit puzzled.

If you haven’t had the pleasure of reading any of Ron Rhoades’ work, the beauty of his writing is that he never leaves the reader in doubt of what he thinks or why he thinks it. His comment to my blog is no exception. His argument is broken down into a five-point logical format worthy of Aristotle:

1) Recruiting bonuses have to be paid out of some revenue stream;2) That revenue has to be obtained from clients somehow;3) That creates a conflict of interest;4) All registered reps who provide personal investment advice are “highly likely” to be fiduciaries under state common law; and5) Therefore: If a fiduciary status has attached, all material facts such as this conflict of interest must be disclosed.

Ron sums it up this way: “Hence, payment of a recruitment bonus, because it puts pressure on the firm and/or the advisory to promote certain proprietary or other [high-cost] products is a material conflict which must be disclosed.”

In a fairness, it’s a powerful argument: the payment of bonuses by brokerage firms does undoubtedly create pressure for brokerage firms to boost their revenues through the only available channel: their clients. But to my mind, its weakness is that it unfairly focuses on recruiting commissions as if they are the sole cause of as conflict arising out of a brokerage firm’s need to maximize revenues generated by its clients.

In practice, broker bonuses are only one of myriad business expenses that create an incentive for brokers and their firms to increase client costs, including: Shark machines, secretaries, travel allowances, management perks, higher payouts, “conferences” in exotic locales and the rent on those glass and chrome high-rises which brokerage firms seem to prefer.

What’s more, if the same anything-that-causes-revenue-pressure-should-be-disclosed-as-a-conflict standard were applied to RIAs, wouldn’t owner/advisors of independent firms have to disclose the kind of company car they drive, their state-of-the-art office technology, and the salaries, bonuses and share of the profits that they and their employees and partners are paid each year? After all, don’t all these costs put pressure on AUM fees to be higher than they might be? My point is that Rhoades’ logic seems to create a major-league slippery slope down which few RIAs want to slide.

What I like most about Ron’s position is that it highlights the conflict inherent in the brokerage advisory model: rather than both client and advisor agreeing on a fair AUM fee upfront (regardless of revenue pressures) as the advisors’ sole compensation, brokerage clients are often subject to hidden or obscured costs and/or fees under the direct control of the broker or their firm.

This can create a material conflict of interest, which would have to be disclosed under a ‘40 Act fiduciary standard—which of course, is why SIFMA and NAIFA are so adamantly opposed to such a standard being applied to registered reps. Perhaps the most client-centered solution would be to separate sales functions from advisory functions: so that clients could choose whether to work with a fiduciary advisor, or a broker representing their brokerage firm.

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